The Fed can fight both inflation and bank contagion
The U.S. Federal Reserve is facing increasing pressure to sacrifice its monetarypolicy goals for the sake of financial stability, on the grounds that its interest-rate increases are to blame for the turmoil in the banking sector.
This is a false choice: The Fed can and should fight inflation and con- tagion at the same time.
Memories of the 2008 financial crisis loom large as one bank after another runs into distress. Investors and depositors take flight faster and with less provocation than ever before, magnifying the effect of shocks such as the demise of Silicon Valley Bank. Larger, healthier banks are less willing to ride to the rescue, daunted by the unanticipated legal liabilities that came with the emergency acquisitions of 2008 — and by the higher capital requirements that the larger, combined institutions would have to meet.
Yet in crucial ways, this is not 2008. The largest banks are more resilient, with bigger capital buffers — one reason deposits have been flowing toward them. Households and businesses are in better financial shape, thanks in part to the huge fiscal transfers during the COVID pandemic. There’s no housing bubble, inflated in part by opaque, complex and extremely fragile financial instruments.
These differences matter, because they mean that if U.S. authorities can restore confidence in the banking system, the recent turmoil won’t do much damage to the economy. Banks as a whole account for a small share of financial intermediation in the U.S., and the handful of troubled regional institutions represents only a few percent of total banking assets. There’s no reason for credit to tighten as much as it did in 2008. The primary problem is losses on longerterm bonds, which can be addressed by taking on less interest-rate risk.
So what does this mean for the Fed? First, it should provide the liquidity needed to support the banking system — as it did last week, for example, by accepting high-quality bonds at face value as collateral for Fed liquidity. By reducing risk and uncertainty, this will allow it to pursue the monetary policy most appropriate for the economy. It needs to demonstrate that it can do both: ensure financial stability as lender of last resort, and reduce inflation by adjusting the level of shortterm interest rates.
Granted, a 50-basis-point interest-rate increase at this week’s policy-making meeting would be reckless, given the unsettled situation. As Fed officials have suggested, destination matters more than speed, and going more slowly gives them more time to assess the effects of previous actions. On the other hand, cutting rates when inflation is still high would be more alarming than calming.
This leaves the Fed to choose between a pause and a 25-basispoint increase. A pause could actually unsettle markets by indicating concern about the health of the banking system, though officials could mitigate this by signaling further increases are likely in the FOMC statements and the Committee’s interest-rate projections. An immediate hike would further squeeze banks’ net interest margins, and could look problematic in hindsight if the banking malaise worsens.
Whatever the Fed decides this week, what matters is that it do what’s needed on the financial stability side as soon as possible, so that it can safely pursue the right monetary policy at future meetings. Funding trouble at a small number of banks shouldn’t get in the way of fighting inflation.
Bill Dudley is a Bloomberg Opinion columnist and senior adviser to Bloomberg Economics. A senior research scholar at Princeton University, he served as president of the Federal Reserve Bank of New York and as vice chairman of the Federal Open Market Committee.